Euro’s Worst Ahead as Analysts See Crisis Spreading

The most accurate foreign-exchange strategists say the euro’s worst annual performance since 2005 will extend into next year as the region’s sovereign-debt crisis saps economic growth.

Standard Chartered Plc, the top overall forecaster in the six quarters ended Sept. 30 based on data compiled by Bloomberg, predicted the euro may weaken to less than $1.20 by mid-2011 from about $1.33 today. Westpac Banking Corp., the second most accurate, is “bearish in the short term,” and No. 3 Wells Fargo & Co. cut its outlook at the end of last week.

The 16-nation currency’s first weekly gain against the dollar since Nov. 5 may prove short-lived amid mounting concern that more nations will need rescues. European Central Bank President Jean-Claude Trichet delayed the end of emergency stimulus measures last week and stepped up government-debt purchases as “acute” market tensions drove yields on Spanish and Italian bonds to the highest levels relative to German bunds since the euro started in 1999.

“We’re going to get a continuation of the problems that Ireland, Portugal, Spain and others are suffering,” said Callum Henderson, Standard Chartered’s global head of foreign-exchange research in Singapore. “The fundamental issue is these are countries that have relatively large debts, large budget deficits, large current-account deficits, they don’t have their own currency and they can’t cut interest rates. The only way they can get out of this is to have significant recessions.”

Sentiment Reverses

Ireland’s budget deficit will rise to more than 32 percent of gross domestic product this year, including the cost of bailing out the nation’s banks, European Commission data from Nov. 29 showed. Spain’s deficit will be 9.3 percent in 2010. Portugal’s total debt will reach almost 83 percent of GDP this year from about 76 percent in 2009, according to the commission.

Just a month ago the euro reached $1.4282, the strongest level since January, as traders sold the dollar on speculation the Federal Reserve would debase the greenback by printing more cash to purchase $600 billion of Treasuries in so-called quantitative easing.

Now, those concerns are being overshadowed by the possibility that Europe’s economy slows next year as governments impose austerity measures to reduce budget deficits, while officials drive bond investors away with talk of forcing them to take losses as part of future bailouts.

Risk Reversals

Demand for options granting the right to sell the euro over the next three months relative to those allowing for purchases reached the highest level since June last week. The so-called 25-delta risk reversal rate fell to negative 2.5225 percentage points from negative 0.5725 in October.

European banks paid the biggest premium to borrow in dollars through the swaps market since May last week, a signal the outlook for the euro may deteriorate. The price of two-year cross-currency basis swaps between euros and dollars reached minus 51.8 basis points on Dec. 1, from minus 20.9 on Nov. 4.

“We have a lot of time to go” before the situation in Europe is resolved, John Taylor chairman of FX Concepts LLC, the world’s biggest currency hedge fund, said Dec. 2 at the Hedge Funds New York Conference hosted by Bloomberg Link. “That means the market is going to be twitching.”

Taylor predicted some nations may leave the common currency. Stronger members “have to say ‘enough, you guys, get out of the euro,’” he said. “The risk that Spain and Italy will get into trouble is going to cause the euro to get quite weak.”

The region’s economy may expand 1.4 percent next year, compared with 2.5 percent in the U.S., according to the median estimate of more than 20 economists in Bloomberg surveys.

Market ‘Tensions’

“Uncertainty is elevated,” Trichet told reporters after the ECB left its benchmark interest rate at 1 percent on Dec. 2. “We have tensions and we have to take them into account.”

The ECB will keep offering banks as much cash as they want through the first quarter over periods of as long as three months at a fixed interest rate, Trichet said. That marks a shift from last month, when he said that the ECB could start limiting access to its funds.

While the euro rose 1.3 percent against the dollar last week, it’s down 5.6 percent from Nov. 4. For the year, it has fallen 6.7 percent, following a gain of 2.51 percent in 2009.

Westpac predicts the euro may weaken to $1.2650-$1.2670 in one month, said Lauren Rosborough, a senior strategist in London. The bank then expects the Fed’s bond-purchase plan to weigh on the dollar, according to Robert Rennie, head of currency research at Westpac in Sydney.

‘Source of Negativity’

“As we progress through next year, we see quantitative easing in the U.S. as an ongoing source of negativity for the U.S. dollar,” Rennie said. “We’ve got the euro up to $1.35 by March and $1.38 by June.”

Federal Reserve Chairman Ben S. Bernanke said yesterday the economy is barely expanding at a sustainable pace and that it’s possible the Fed may expand bond purchases beyond the $600 billion announced last month to spur growth.

Unlike the Fed, the ECB isn’t conducting quantitative easing. That helped keep the euro from matching this year’s low of $1.1877 reached on June 7.

Outside of the most accurate forecasters, strategists are hesitant to reduce their estimates. Even as the euro slumped 6.9 percent last month, the median mid-2011 estimate of 41 strategists surveyed by Bloomberg rose to $1.36 from $1.35.

Germany is making up for some of the weakness in the economies of Greece, Ireland, Portugal and Spain. Last week the Nuremberg-based Federal Labor Agency said the number of Germans out of work declined a seasonally adjusted 9,000 to 3.14 million, the lowest level since December 1992. German business confidence surged to a record in November as domestic spending increased, the Ifo institute in Munich said on Nov. 24.

Trichet’s Signal

Trichet signaled on Nov. 30 that investors are underestimating policy makers’ determination to shore up the region’s stability. He said in Paris on Dec. 3 that euro-area governments need a “quasi” fiscal union.

“There will be sufficient political will to find measures that will bind the system together,” said Jane Foley, a London- based senior currency strategist at Rabobank International, one of the most bullish on the euro among the most accurate forecasters. “The euro will come out of this stronger.”

Foley said the euro will strengthen to $1.40 in the first quarter and to $1.45 by the end of June.

Traders are anticipating more declines as the U.S. economy picks up speed.

Diverging Economies

The U.S. created jobs in November for a second month, data from the Labor Department in Washington showed Dec. 3. Two days earlier, the Institute for Supply Management’s factory index showed manufacturing expanded for a 16th month. By contrast, growth in Europe’s GDP slowed to 0.4 percent in the third quarter from 1 percent in the three months ended June 30, according to EU figures on Dec. 2.

As the euro region’s most-indebted nations cut spending to bring their deficits under control, a weaker euro will be needed to cushion their economies, said Ian Stannard, a senior currency strategist in London at BNP Paribas SA, the fifth most accurate forecaster. The bank says the euro will trade at $1.25 by the end of June and $1.20 in the third quarter.

Declines in the bonds of euro-region members including Ireland and Spain have accelerated after EU leaders agreed on Oct. 29 to consider German Chancellor Angela Merkel’s proposal to force bondholders to share the cost of future bailouts.

Wells Cuts

The crisis prompted Wells Fargo to lower its first-quarter target for the euro to $1.37-$1.38 from a November forecast of $1.41, said Nick Bennenbroek, head of foreign-exchange strategy in New York. He sees the currency at $1.25 by late next year.

The debt crisis “will remain with us for longer, which is why we lowered our targets,” he said. “The move in the euro has been particularly rapid and you can say the currency markets have been panic driven, so we feel like it’s overdone. We do expect the euro to fall over time but we expect the decline to be more orderly than has been the case recently.”

Companies participating in the ranking were compared based on seven criteria: six forecasts at the end of each quarter for the close of the next, starting in March 2009, plus one annual estimate, which was made at the end of September 2009 for currency rates as of Sept. 30, 2010.

Only firms with at least four forecasts for a particular currency pair were ranked for it, and only those that qualified in at least five of eight pairs were included in the ranking of best overall predictors.